Markets have been grinding quietly higher over the last week, as investors await additional guidance from earnings reports and inflation data arriving this week. Amid the calm however, lurks the potential for a significant explosion in volatility, which could have a dramatic impact on both stocks and VIX ETFs.
Stocks and index ETFs have been grinding steadily higher, but overall movement seems quite, as volatility continues to compress, with the S&P 500 essentially within 1% for five sessions in a row. The VIX, or volatility index, has fallen below levels not seen since before the pandemic, trading below 19, as investors champion the reopening of the economy. The move has been meaningful for ETFs like the iPath Series B S&P 500 VIX Short Term Futures ETN (NYSEArca: VXX), which could see massive moves if volatility reverses course.
A massive trade in the U.S. options market on Thursday appears to be betting that the calm enveloping U.S. stocks in recent weeks will give way to a big rise in volatility over the next three months.
Last week, one or more traders laid out an approximately $40 million bet that the Cboe Volatility Index (VIX), aka “the fear gauge,” will breach the 25 level and climb towards 40 by mid-July, trading data showed Thursday.
The VIX closed at 16.95 on Thursday, its lowest close since February 20, 2020, just before the coronavirus pandemic sent investors scrambling to exit positions slammed global financial markets.
Roughly 200,000 of the VIX July 25 – 40 call spread traded over the course of two hours on Thursday. The trades accounted for about a third of the average daily trading volume in VIX options, according to Trade Alert.
The trades involved the purchase of the spread’s lower strike calls for an average price of about $3.37, partly funded through the sale of the higher strike calls at about $1.30 per contract. The mid-July target of 25 would allow the trade to be profitable, something that would likely mean a tumultuous period for stocks that could include significant downside if it came to pass.
Why All the VIX Hubbub?
The VIX has been a reasonable prognosticator of periods of calm and crisis.
Periods where the VIX was consistently above 20 have included: the US recession of 1991, the emerging market financial crises in late 1990s, the US recession of 2001, the US recession of 2008, the European financial crisis of 2012, and most recently, the US recession of 2020.
Meanwhile, sustained periods when the Cboe Volatility Index is below 20 often correspond with prosperity or economic recovery.
While we are at the precipice of such a period, with the VIX currently trading around 18 and yet to reveal its hand, ETF investors interested in trading the VIX have several options at their disposal.
The ProShares Short VIX ETF (SVXY) climbs as VIX falls, and, according to the fund’s profile: “The investment seeks daily investment results, before fees and expenses, that correspond to one-half the inverse (-0.5x) of the performance of the S&P 500 VIX Short-Term Futures Index for a single day. The index seeks to offer exposure to market volatility through publicly traded futures markets and is designed to measure the implied volatility of the S&P 500 over 30 days in the future.”
Investors looking to use ETFs to trade the VIX over the short-term can also look at the iPath Series B S&P 500 VIX Short Term Futures ETN (NYSEArca: VXX) and the ProShares VIX Short-Term Futures ETF (NYSEArca: VIXY), along with the CBOE Volatility Index. Potential investors should note that VIX-related exchange traded products track VIX futures and not the spot price.
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